How Do Annuities Work? - James K. Ault

The way annuities work may at first seem a bit complicated. That’s because these financial products can have many moving parts. But, by having a good understanding of the benefits, you could enhance the income you receive in retirement, as well as your tax-advantaged savings options during your working years.

Annuities are an insurance product, and because of that, they offer some enticing guarantees – which include the ability to continue paying you an income stream for your entire life, regardless of how long that may be.

Because of this, owning an annuity can alleviate one of the biggest fears on the minds of retirees – running out of money in the future. So, stop asking yourself “how do annuities work?”, and allow the experts at Sooner Retirement to help you to narrow down which annuity (if any) is right for you and your financial objectives.

The Annuity Explained – Making a Complex Financial Topic Easy to Understand

Although annuities have become more popular over the past decade or so, these financial vehicles have actually been around for thousands of years. In fact, they are one of the oldest forms of investments, dating all the way back to the Roman Empire.

The most common question we get is “how do annuities work? ” We’re here to help answer that. In their most basic sense, annuities are defined as a contract between an individual and an insurance company. This contract can guarantee the annuitant (i.e. the person on whose life the annuity is based) an income that cannot be outlived.

This makes annuities a good option for those who are seeking a reliable source of incoming cash flow. In addition to an income stream, though, annuities can also offer a long list of additional benefits.

Sorting Out the Different Types of Annuities

One of the most distinguishing features of an annuity is whether it is fixed or variable. While both types of annuities may be funded in a similar manner – and also offer like payout options – there is a definite difference between how the different types of annuities operate. Let’s dive in to discover how annuities work.

Fixed Annuities – With a fixed index annuity a set amount of interest is credited on an annual basis. The rate of return is set by the issuing insurance company. Although the insurer may revise the rate over time, there is typically a guaranteed minimum interest rate below which the return won’t fall. This is the case, regardless of what happens in the market, or even in the economy overall. The funds that are inside of a fixed annuity are allowed to grow on a tax deferred basis. This means that the account value essentially earns a return on the principal, as well as on the interest, and on the amount that would otherwise have been paid out in taxes each year. One of the biggest draws for fixed annuities is the safety of principal they can provide. Fixed annuities can also pay out a set income stream for a certain period of time (such as 10 or 20 years), or even for the remainder of your lifetime…regardless of how long that may be. So, it is easy to see why retirees can feel more secure when they have a reliable stream of income that they can count on. In fact, research has shown that people who have a guaranteed income stream in retirement are not only happier, but also healthier.
Variable Annuities – Variable annuities allow their holders to participate in stock market-linked appreciation, based on the return of underlying assets such as mutual funds. The funds in a variable annuity account are not invested directly into these investments, but rather they are placed in the insurance company’s sub-accounts. If the underlying investments perform well, a variable annuity can produce a nice return. On the other hand, though, if these investments perform poorly, it can result in a loss. So, just like investing in stocks and mutual funds directly, there is some risk to be mindful of when you own a variable annuity. Like a fixed annuity, the funds inside of a variable annuity are allowed to grow tax-deferred. Variable annuities can also pay out an income stream for a set period of time, or for the remainder of your life.
Indexed Annuities – A somewhat “newer” type of annuity in the marketplace is the indexed contract. With an indexed annuity, your return will be based on the performance of an underlying index, such as the S&P 500. In this case, if the index performs well, the annuity will be credited with a positive return – typically up to a certain “cap” or maximum. But, if the underlying index performs poorly during a given period, the annuity is not hit with a loss. Rather, the account is simply credited with a 0% return for that time frame. Because there are no negative returns associated with an indexed annuity, future gains can continue growing, without having to make up for any losses. Tax-deferred growth is also allowed with indexed annuities, so there is no taxation on the gains until the time of withdrawal. Likewise, there are several different income options to choose from if you own an indexed annuity.

In addition to the way in which the return is calculated, annuities can be further separated into immediate and deferred categories.

Immediate Annuity – With an immediate annuity, a single lump sum deposit is typically contributed to the annuity. This contribution can come from personal savings, or alternatively, money may be rolled over into the annuity from retirement savings like a traditional IRA or a 401(k) plan. Income from an immediate annuity begins right away – generally within 12 months of when you initially purchase the annuity.
Deferred Annuity – Deferred annuities also provide an income stream. But the income from this type of annuity usually doesn’t start until a time in the future (in some cases, up to 30 or 40 years). Therefore, deferred annuities have two distinct phases – the accumulation phase and the income payout phase. During the accumulation phase, funds can grow and compound. These annuities allow you to make one single contribution, or alternatively, numerous contributions over time. Deferred annuities generally offer several different income payout options. These can include period certain – or a term certain annuity – where income is paid for a set number of years, and lifetime income – also referred to as a life annuity – where income continues to be paid for the remainder of your lifetime.

Many annuities offer additional features, too. In some cases, these add-ons are included at no additional charge, while others will require you to pay an additional amount of premium. One feature that many annuities include is a death benefit whereby if the annuitant passes away prior to receiving all of their contributions back, the remainder of the funds are paid to a named beneficiary.

This annuity death benefit can be taken either as a single lump sum, or alternatively as a stream of payments. Unlike the death benefit from a life insurance policy, though, annuity death benefits are usually taxable.

There may also be a terminal illness and/or nursing home waiver on many annuities. With these features, if the annuitant is diagnosed with a terminal illness or has to reside in a nursing home for a certain period of time, funds may be accessed from the annuity penalty-free.

What Do You Want an Annuity to Do?

While annuity guaranteed income is certainly a key benefit with these financial vehicles, there are other ways that annuities can help you reach your financial goals. In order to ensure you have the right annuity in place, though, it is important that you know what you want the annuity to do.

For instance, while many retirees love knowing that they will have a reliable income to count on in the future, other investors may prefer the tax-deferral that annuities provide during the accumulation period. This is particularly the case if the annual contribution on their qualified savings plans like an IRA and employer-sponsored plan has been “maxed out”.

Annuity vs 401(k) Benefits

Both 401(k) plans and annuities are considered financial vehicles that can help you to save for retirement. Therefore, these options have some similarities and some differences. The good news is that there is actually a way to benefit from both.

In terms of their similarities, annuities and 401(k) plans allow your savings to grow on a tax-deferred basis. This means that your funds can compound year after year without be subject to tax until the time of withdrawal.

When it comes to providing an income stream, though, annuities and 401(k) plans can differ quite a bit. For instance, a 401(k) can only pay out the amount of money you put into it, plus its earnings. This means that eventually, these funds may run out.

On the other hand, with the lifetime income option on an annuity, you can rely on an income stream for the remainder of your life – even if you live for many years. This is true, regardless of what happens in the stock market, or even in the economy overall. For this reason alone, it proves how important it is to understand how annuities work, especially when compared to 401(k) plans.

Annuity Pros and Cons

Just like any other type of financial vehicle, annuities can have both pros and cons. For instance, there are a number of annuity advantages, such as:

Tax-deferred growth. Given their tax-deferred nature, the funds in an annuity have the ability to grow and compound exponentially, unlike money that is invested in taxable accounts.
Principal protection (with fixed and indexed annuities). Regardless of what happens in the stock market, you won’t incur a loss with a fixed or a fixed indexed annuity. This safety can be reassuring, especially as you get closer to retirement.
Income you cannot outlive. Because people are living longer life spans today, knowing that you can rely on an income stream for the remainder of your lifetime can allow you to enjoy retirement to the fullest.

Yet, even with all of the benefits that annuities offer, there can also be some drawbacks to be mindful of. First, annuities are not very liquid. For instance, in most cases, you may only withdraw up to 10% of your contract value each year.

However, if you take out more than that during the annuity’s surrender period, you can incur a withdrawal charge. On some annuities, the surrender period can last up to 10 years, or even longer.

In addition, if you withdraw money from an annuity before you are age 59 ½, you may also be hit with a 10% “early withdrawal” penalty from the IRS. So, annuities should always be considered a long-term financial commitment.

With that in mind, another item to consider is annuity fees. Most annuities will have surrender fees. Depending on the annuity, there may also be an agent commission deducted from your contribution when you purchase it.

Variable annuities will typically have some additional fees, as well. Depending on the particular variable annuity, these fees can include:

Mortality & Expense (M&E) charges
Administrative fees
Contract fees
Distribution charges

Keep in mind that variable annuity fees are not just based on the annuity itself, but they can also be garnered from each of the individual investment options you have chosen. Altogether, variable annuity fees can often cut into 2% or more of your annual return.

Is an Annuity Right for You?

Although annuities can provide a number of enticing benefits – such as tax-deferred growth and a guaranteed income stream – these financial vehicles may not be the right fit for everybody.

Further, even if you can benefit from an annuity, there are many different types of these products available in the marketplace. So, it can help to work with an annuity specialist who can assist you with narrowing down the right one for you and your specific objectives.

Sooner Retirement provides in-depth education about annuities to consumers and financial professionals, making these complex financial vehicles much easier to understand. We also offer in-depth details and reviews on hundreds of annuities in our annuity review database. Learning about how annuities work is essential for determining whether or not a particular annuity may be right for you.